In passing the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank), Congress has attempted to close loopholes in
connection with the regulation of retail foreign exchange (forex) transactions.
In light of the Dodd-Frank legislation, as well as forex-related rules adopted
by self-regulatory-organizations, broker-dealers must be cognizant of
activities that may involve retail forex transactions in various ways. For
example, as further discussed below, customer trading in "foreign ordinaries,"
i.e., equity securities exclusively traded overseas, may lead broker-dealers to
engage in retail forex trading, potentially subjecting them to forex-related
regulation (either now or in the near future) by the SEC, CFTC, NFA, or FINRA.
Background on Forex Regulation
Prior to 2000, foreign currency trading by retail
customers was largely unregulated. Congress attempted to address this situation
in Commodity Futures Modernization Act of 2000. This law gave the CFTC the
authority to regulate over-the-counter futures transactions involving a retail
customer on one side of the trade. The CFTC was not, however, given
jurisdiction to regulate OTC spot transactions, which normally settle in two
days. Acting on this authority, the CFTC brought an enforcement case against a
foreign exchange dealer that was offering retail customers the opportunity to
buy and sell foreign currency contracts that nominally settled in two days (the
normal settlement cycle for foreign currency trades), but in reality were
virtually always rolled over into a new contract without settlement actually
taking place until the transaction was offset.
The case was ultimately appealed to the Seventh Circuit
Court of Appeals, which ruled in CFTC v. Zelener that rolling spot
transactions were, in fact, spot transactions and, therefore, the CFTC had no
jurisdiction to pursue its enforcement case.
Congress tried again in 2008 to address retail forex
trading by amending the Commodities Exchange Act to regulate any OTC forex
transaction involving a retail customer that did not, in fact, settle in two
days by actual delivery of foreign currency. However, the law contained various
exceptions for entities that were regulated by other regulators, such as
insurance regulators or the SEC. The law went so far as to exclude "investment
banking holding companies" which include all affiliates for a broker-dealer
holding company. Thus, once again, an enterprising entrepreneur could avoid
regulation, in this case by affiliating with an excluded entity.
Congress has tried a third time to get it right by
including expanded regulatory authority over retail forex transactions in
Dodd-Frank. This time, Congress has given regulatory jurisdiction to a number
of federal regulators, hoping to close the loopholes created in 2008.
Unfortunately, there have been unforeseen consequences.
Customer Trading of Foreign Ordinaries
For years, many broker-dealers have offered their
customers the opportunity to buy and sell foreign ordinaries. In order to
settle these transactions, brokers must necessarily convert customer dollars
into foreign currency and back again. In the typical transaction, a broker
would forward a customer order to a correspondent overseas, who would execute
the transaction in the foreign market in the local currency. On settlement
date, the executing firm would settle the transaction in the local currency,
thereby necessitating either that it convert U.S. dollars into the local
currency or that the introducing firm do the conversion. Ultimately, the U.S.
customer would settle the trade in U.S. dollars without having to get involved
in the actual currency conversion, in much that same way that credit card
companies settle foreign credit card purchases with their customers in U.S.
Of course, this begs the question, now raised by
Dodd-Frank, whether the purchase and sale of foreign ordinaries involves a
retail forex transaction.
Mechanics of Forex Transactions
Spot forex transactions normally settle on the second day
after trade date (T+2) and are expressly excluded from Dodd-Frank. Securities
transactions, including trades in foreign ordinaries, however, settle on the
third day after trade date (T+3); consequently, if a customer were to purchase
and sell forex to coincide with foreign ordinary trading, settlement would be
on T+3 and therefore subject to regulation. Although it is possible to settle
purchases of forex on T+2, one day ahead of foreign ordinary settlement, it is
not possible to settle sales of forex in conjunction with foreign ordinary
sales on T+2, because proceeds from the sale of foreign ordinaries would not be
available until T+3. As a result, forex trading that is incurred in connection
with trading of foreign ordinaries may involve broker-dealers in regulated
retail forex transactions.
In recognition of this issue, on July 13, 2011, the SEC
issued temporary final rules that in essence extended the effective date of
forex regulation on broker-dealers for one year. Notwithstanding this deferral,
firms must recognize that self-regulators have not deferred the applicability
of their regulations with respect to retail forex transactions by
Regulators and Who They Regulate
CFTC. The CFTC is authorized to
adopt registration rules and other requirements for retail forex dealers
subject to its exclusive jurisdiction or unregulated by another federal agency.
This would include FCMs that are registered with the CFTC but not subject to
SEC or banking regulation, as well as dealers that are not regulated by any
federal regulator (RFEDs).
The CFTC also is permitted to regulate any person
soliciting retail forex transactions, including introducing brokers, as long as
the person is not regulated by the SEC or a banking regulator.
SEC and Other Regulators.
Under Dodd-Frank the SEC now has express authority to adopt rules regulating
forex dealers that are broker-dealers. The statutory provisions would prohibit
a broker-dealer from acting as a forex dealer absent enabling SEC regulations.
On July 13, 2011, the SEC adopted rules that impose no new requirements for
broker-dealers acting as forex dealers for one year in order for the SEC to
study the impact of regulations in trading in foreign ordinaries among other
Applicable statutory provisions do not prohibit
self-regulatory organizations from regulating the activities of their members
even though the federal regulator itself is prohibited from regulating those
subject to its jurisdiction. As a result, both the NFA and FINRA have adopted
rules governing retail forex activities of their members.
NFA. The NFA has amended its
rules to establish a new category of membership, a Forex Dealer Member. As of
October 1, 2011, this category will include any NFA member that acts as
counterparty or offers to act as counterparty to a retail customer in a forex
trade. Thus, any broker-dealer that is an NFA member and is acting as principal
in retail forex trades would have to register as an NFA Forex Dealer Member and
would be subject to a variety of NFA regulations.
In addition, various NFA rules of general application to
its members may apply with respect to a broker-dealer's retail forex
activities, such as NFA Compliance Rule 2-29 on Communications with the Public
and Promotional materials and related NFA notices.
Broker-dealers that are NFA members but do not intend on
acting as principal in forex trades, but introduce their customers to another
forex dealer, are not required to register as Forex Dealer Members, but are
still subject to a variety of NFA regulations.
FINRA. In 2008, FINRA issued a
notice to members (No. 08-66) advising them that certain FINRA rules will apply
to members with respect to their retail forex transactions. Most importantly,
FINRA states that engaging in retail forex activity entails a material change
in business activity and, therefore, a firm proposing to engage in this
activity must file a Rule 1017 application for a change in its membership
agreement. FINRA also stated that its "catch-all" Rule 2110, requiring members
to act in a just and equitable way, applies to retail forex transactions.
However, FINRA states that it will look to NFA rules and interpretations as the
applicable standards under Rule 2110. Finally, FINRA states that its
advertising Rule 2210 will apply to retail forex activities.
Customer Funds Protection Considerations
If a broker-dealer carries customer accounts that include
forex, it will be required to treat all forex positions as the equivalent of
free credit balances for purposes of SEC Rule 15c3-3. This means that it may
have to make Special Reserve Account deposits reflecting foreign currency
positions maintained by it or its clearing firm if forex positions are held on
an omnibus basis.
For more information about LexisNexis
products and solutions connect with us through our corporate site.